Last Updated on September 23, 2022 by Oddmund Groette
It is important to be able to identify the beginning of a new trend; equally, it is also important to be able to identify the end of a trend. A well-timed entry fits perfectly with a well-timed exit. The parabolic stop and reverse (SAR) indicator is one trading tool that can tell us a lot about the trend. Let’s take a look at this indicator to see how it works and how it is calculated.
The Parabolic Stop and Reverse is a trend-following indicator that tells the direction of the price of a security and also highlights entry and exit points in the market. When it is above price, the market is considered to be bearish. On the other hand, the market is said to be bullish when the indicator is below the market.
Is this a tradable strategy? In this article, we backtest two Parabolic Sar trading strategies.
What is the Parabolic SAR?
The Parabolic Stop and Reverse (SAR) is a trend-following indicator that tells the direction of the price of a security and also highlights entry and exit points in the market. When it is above price, the market is considered to be bearish. On the other hand, the market is said to be bullish when the indicator is below the market.
Visually, the Parabolic SAR is seen as a series of dots above or below the price bars. It works best in a trending market. As the price of a security rally, the dots will follow suit, first insidiously and then almost in sync with the price. As the trend gain momentum, the dots start to develop at a quicker rate and then catch up with the price bars — one dot under each completed price bar. Similarly, when the market is in a downtrend, the dots gradually start appearing above the price bars and then increase until it becomes one dot above each price bar. The dots may not appear during periods of transition between uptrend and downtrend.
Here is an example of how the Parabolic Sar looks like on a chart:
The continuous movement of the dots above or below the price bars generates signals that could be profitable when the market makes a significant move. Consequently, the indicator is rather not effective in a range-bound market.
This indicator can be used to create a trading system when combined with another tool that shows the direction of the market. In that case, a long trade is taken only when the market is in an uptrend and a short trade when the market is in a downtrend.
The Parabolic SAR is also used for setting stop-loss orders in the market. The trailing stop follows the indicator ascends or descends. For example, in a long position, the trailing stop-loss can be set to stay just below the last dot, the next dot, or anyone you want. For a short position, the trailing stop stays above the dots.
What is the formula?
The Parabolic SAR uses the highest and lowest price as well as the acceleration factor to determine where the SAR indicator dot will be displayed. It calculates the swing point (high – low) of an individual price bar and the acceleration factor and adds it to the previous SAR for each bullish SAR, but subtracts it from the previous SAR for each bearish SAR.
The formula for the Parabolic SAR is as follows:
EP = the swing in a trend (highest high reached in an uptrend or lowest low reached in a downtrend).
AF = the acceleration factor which is 0.02 initially (it increases by 0.002 as a new EP is computed, up to a maximum of 0.2). You can tweak the AF depending on your trading style.
The value obtained from this calculation is plotted as a series of dots either above or below the price action. Most trading platforms have the indicator, so you don’t need to do the calculation and plotting manually. Even where the indicator is not built-in, you can code a custom indicator or pay someone to do that for you.
Who invented the Parabolic SAR?
The Parabolic SAR was created and first used by J Welled Wilder Jr., the renowned trader who create the Relative Strength Index indicator and the Average Directional Index indicator (ADX). He developed the Parabolic SAR for three basic reasons: to identify the current trend, to predict turning points in the current trend, and to show potential entry and exit points during a trend reversal.
What does the Parabolic SAR tell you?
The Parabolic SAR indicates three things.
First, it tells you where the market is likely headed (up or down) — this is shown as a series of dots above or below the market depending on the current trend. Secondly, it attempts to tell you at what point the current trend will likely reverse. Lastly, it can tell you potential entry or exits based on a market trend reversal.
However, a buy signal occurs only when the dots have moved below the price bars and are green in color. Similarly, a sell signal occurs when the dots have moved above the price bars and are red.
When holding a long position, the first sign of a red dot above the market is considered a bearish signal, and a reversal is due. This is the normal time for many to close their long position and open a short one in the same security. Likewise, when holding a short position, a green dot below the market is seen as bullish and a sign of a potential reversal — an appropriate time to short position and open a long one in the same security.
To wrap it up, the Parabolic SAR is a useful trend indicator, but as with other indicators, it’s far from 100% accurate. Combine it with other indicators that show the strength of the trend. Above all, be sure to backtest and optimize whatever strategy and system you create with the indicator.
This is the theory and the logic based on the writings of Welles Wilder. Does the theory work? Let’s go on to backtest some Parabolic Sar trading strategies:
Parabolic Sar trading strategy no 1
Let’s go on to backtest our first Parabolic Sar trading strategy. Below is the trading rules in plain English:
- When the Parabolic Sar crosses above the close, we go long.
- When the close crosses above the Parabolic Sar, we sell our position.
We use the default Parabolic Sar default settings and we backtest on S&P 500 (SPY). The equity curve looks like this (what is a good equity curve?)
The number of trades is 368, the average gain per trade is 0.56%, the win rate is 73% (what is a good win rate in trading?), max drawdown is 41% (what is a good maximum drawdown?), and the profit factor is 1.6.
Does the strategy work better on other assets? We tested on many other assets, including commodities, but with no luck. We even changed the settings and rules but with not much improvement.
Parabolic Sar trading strategy no 2
Let’s flip the rules from strategy no 1:
- When the close crosses above the Parabolic Sar, we buy at the close.
- When the Parabolic Sar crosses above the close, we sell at the close.
Again, we backtest on the S&P 500:
The chart pretty much says it all: a really poor strategy.
Parabolic Sar Strategy – Amibroker code
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Parabolic Sar trading strategy – ending remarks
We didn’t manage to find any particular best settings for the Parabolic Sar, and neither did we manage to find any good Parabolic Sar trading strategy. The indicator is profitable, but there are many other trading indicators that work better.